Beyond The 4% Rule
Page 11
Dimson, Elroy; Marsh, Paul; Staunton, Mike. Triumph of the Optimists: 101 Years of Global Investment Returns (Page 127). Princeton University Press. Kindle Edition.
Pfau (2014): Does International Diversification Improve Safe Withdrawal Rates? https://www.advisorperspectives.com/articles/2014/03/04/does-international-diversification-improve-safe-withdrawal-rates
Cassaday, Stephan (2006). “DIESEL: A System for Generating Cash Flow During Retirement”, Journal of Financial Planning, September 2006
Blanchett, David M. 2013. “The ABCDs of Retirement Success.” Journal of Financial Planning, vol. 26, no. 5 (June): 38-45
CHAPTER 10
All together: baking the layer cake of sustainable withdrawal rate
So, we’ve considered the key factors that affect sustainable income in a retirement portfolio. Now the question is, how do we bring them together to construct a sustainable withdrawal strategy?
Bengen52 (2006) suggests an approach similar to baking a cake. First, we determine the foundation layer (the main withdrawal strategy), then we decide which other layers we want to add.
Here’s a list of the key factors that affect the layer cake:
foundation withdrawal strategy (inflation adjustment)
asset allocation (including small cap/value)
probability of success
fees
longevity adjustment
bequest
expected investment alpha
To illustrate this layer cake approach, I’m going to use a couple of scenarios. First, James and Janet Balance. Mr and Mrs Balance are both 65 and both drawing their State Pension. They’re looking for a stable income from their £200,000 portfolio.
They talk to their financial adviser and agree to invest in a balanced portfolio. The Balances want to adjust their withdrawal with inflation each year and feel comfortable with a 90% probability of success. They’re prepared to take less from their portfolio, but only if market conditions force them to. Of course, they have the house to fall back on if they need.
Their adviser bakes their withdrawal layer cake like this:
90% Probability of success (longevity adjusted) +0.4%
Half of equity allocation (30%) invested in small cap/value +0.5%
60/40 asset allocation (rather than 50/50) +0.1%
Base withdrawal strategy: Bengen’s constant inflation adjustment 3.1%
Fees (1% pa) -0.5%
They end up with a sustainable withdrawal rate of 3.6% in the first year of retirement. This gives them an annual income of £7,200pa, based on their £200,000 portfolio.
Next, we meet Mr Cooks. He’s 65, single and just started drawing his State Pension. His house is paid off and he has a portfolio of £300,000.
Cooks wants to enjoy his retirement while he can and intends to do a bit of travelling before winding down gradually. So, he quite likes the idea of being able to spend more early in his retirement and plans to spend progressively less as he gets older.
In terms of risk appetite, he’s prepared to stomach some volatility. He agreed a 70/30 portfolio and an 80% probability of success with his adviser, after much discussion. He fully accepts that if he experiences poor market conditions in the early stage of his retirement, he might have to curtail his travels a bit. But that’s a risk he’s prepared to accept.
His financial planner bakes his withdrawal layer cake like this:
No request goal 0%
80% Probability of success (longevity adjusted) +0.7%
Half of equity allocation invested in small cap/value +0.25%
70/30 asset allocation (rather than 50/50) +0.3%
Base withdrawal strategy: Guyton guardrail strategy 3.5%
Fees (1% pa) -0.5%
This scenario results in an initial withdrawal rate of 4.25%. It gives him an annual income £12,750pa on top of his State Pension.
Withdrawal policy statement
Making sure a retirement portfolio lasts a lifetime is a bit like running an egg-and-spoon race.
Managing withdrawals is a delicate balancing act, thanks to the complex and nuanced nature of mitigating sequence and longevity risk. It’s challenging for retirees to stay on track when they’re making portfolio withdrawals – especially with markets throwing tantrums at the same time, like a toddler deprived of its toys.
We’ve already seen that managing a retirement portfolio involves making several complex decisions. They include:
the baseline withdrawal strategy
the withdrawal rates
asset allocation and portfolio management strategy
what proportion of portfolio (if any) to hold as a cash buffer
in what order to liquidate asset classes and tax wrappers
how to deal with one-off lump sum withdrawals over and above normal income needs
Often these decisions have to be made in client meetings and sometimes in the middle of a market tantrum. Most of these decisions and the trigger conditions have been pre-agreed, but they can still be unsettling and stressful for clients. At worst, clients can forget what’s been agreed and they may have the impression that their planner is simply making things up as they go along.
Having a withdrawal policy statement (WPS) helps advisers and clients to have a pre-agreed framework in place to deal with these decisions. It’s impossible for a planner to anticipate every possible market condition in advance. But, a WPS provides an anchor point for both clients and advisers when they’re in the middle of a rapidly changing world.
Many planners have adopted an investment policy statement (IPS) as a set of guiding principles for decision making around asset allocation, re-balancing and discipline in the face of market turbulence. A WPS is a similar set of guiding principles around retirement portfolio withdrawals.
Financial planner Jonathan Guyton 53, one of the early proponents of the WPS, notes that, ‘a withdrawal policy statement specifies the goals, policies, and parameters that the client and adviser agree to adopt to guide future decision-making regarding the use of the client’s financial capital to help fund their lifestyle during their retirement years.’
Guyton lists the essential components of a WPS as:
the client income goals
the client assets the WPS applies to
the initial withdrawal rate
the method for determining the source of each year’s withdrawal income from the portfolio
the method for determining the withdrawal amount in subsequent years, including the trigger points for adjustments (other than an inflation-based increase) and the size of the adjustment
I believe that everything that has an impact on the withdrawal strategy should be included in the WPS.
A good WPS isn’t a financial plan or a suitability report. It’s a set of guiding principles about how to manage a client’s withdrawal in line with their income objectives. The policy should be broad enough to encompass unexpected events as they happen and specific enough so the planner is rarely in doubt about the action to take when things change.
Of course, it’s possible to implement a withdrawal strategy without a WPS. But because many of the strategies can have a direct impact on a client’s lifestyle – such as freezing withdrawals (rather than increasing in line with inflation) or even a slight reduction in the withdrawal in extreme market conditions – having the client agree the WPS makes the process a lot more manageable. Crucially, it helps to avoid the impression that the adviser is making things up as they go along.
For instance, a client could agree a plan to:
withdraw £10,000pa from a starting portfolio of £250,000
increase the withdrawal amount with inflation each year, unless the previous year’s portfolio total return was negative and meant the current withdrawal rate is bigger than the starting withdrawal rate
reduce spending by 10%, if the current withdrawal rate is more than 20% above the starting withdrawal rate (eg if the starting rate was 5%, then t
he threshold is 6%)
The plan sounds reasonable, but clients will forget about it as they get on with their daily lives. And that’s what you’d expect – it’s why they hired an adviser in the first place. But when market conditions dictate that withdrawals have to be frozen or even cut by 10%, clients may not take too kindly to that idea if there isn’t a written withdrawal policy statement. The opposite is also true. Clients could be unnecessarily anxious about normal market volatility if they don’t have a written withdrawal policy statement.
Final words
Retirement income planning is one of the biggest financial challenges of the 21st century. It also presents an incredible opportunity for advisers to help clients navigate a complicated and potentially treacherous landscape at a crucial stage of their lives. However, this opportunity brings significant responsibility.
Given the enormous risks involved, retirement income planning should be viewed as a specialist area of its own. Advisers should only apply practices that are based on the best empirical and rigorous evidence available. If they don’t, it’ll mean poor outcomes for clients and eventually, for advisers.
Retirement planning is akin to mountaineering in many ways. Accumulation is the ascent and the decumulation stage is the descent. Financial planners are like mountain guides – financial Sherpas if you like.
Any mountain guide worth their salt will tell you that the skills needed to reach the summit are quite different to those for getting back down. They’ll help you understand the risks associated with both legs of the journey and do their best to help you avoid them.
Take the earth’s highest mountain, Mount Everest. Reaching its 8,848m summit is an achievement of epic proportions. But we don’t often hear about the fatalities. There are no official records, but it’s believed that around 280 climbers have died on Everest compared to around 4,000 climbers who’ve reached the summit.
Research in the British Medical Journal54 shows that most climbers who die on Mount Everest do so above 8000m, usually during the descent from the summit. According to mountain climbing expert Stewart Green55, most deaths occur while descending the upper slope, after they’ve reached the summit. It’s in the area above 8,000m called the ‘Death Zone.’ The high elevation and corresponding lack of oxygen coupled with extreme temperatures, weather and some dangerous icefalls, create a greater risk of death than on the ascent.
Reaching the summit of a mountain is an incredible achievement, but it’s a halfway point. American mountaineer Ed Viesturs, who has climbed Mount Everest seven times, puts it rather succinctly, ‘getting to the summit is optional; getting down is mandatory.’ The summit is also the point of maximum risk.
Thankfully, most climbers avoid the dangers thanks to the Sherpas they hire to help carry gear, install ropes, and break tracks.
This is true for retirement income planning. As financial Sherpas, advisers owe it to their clients to understand the particular dangers associated with the ‘descent’ and employ the best strategies to help them get to base as safely as possible.
Bengen, William P. “Baking a Withdrawal Plan ‘Layer Cake’ for Your Retirement Clients”. Journal of Financial Planning, August 2006
Guyton J (2010): The Withdrawal Policy Statement. Journal of Financial Planning, June 2010.
Firth P G et all (2008) Mortality on Mount Everest, 1921-2006: BMJ 2008; 337 doi: http://dx.doi.org/10.1136/bmj.a2654 (Published 11 December 2008) :BMJ 2008;337:a2654
Death on Mount Everest: How Climbers Die on Mount Everest http://climbing.about.com/od/mountainclimbing/a/Death-On-Mount-Everest.htm
About the author
Abraham is the creator of Timelineapp.co, a web-based software that illustrates sustainable withdrawal strategies. It’s used by financial firms in UK, US, Canada, Australia and other developed countries. He is the founder of investment and retirement research consultancy, FinalytiQ. He hosts the annual Science of Retirement Conference in London, the go-to event for investment professionals looking to gain in-depth research-based insight on retirement income planning.
He’s recognised as one of the country’s leading experts in retirement income and investment propositions. Abraham has authored several industry papers and delivered talks to the Financial Conduct Authority (FCA), Chartered Insurance Institute (CII), the Personal Finance Society (PFS), the Association of British Insurers (ABI) and several conferences across the country.
He holds a Master’s degree from Coventry University and an alphabet soup of qualifications, including the Investment Management Certificate, Chartered Financial Planner, Certified Financial Planner (CFP) and Chartered Wealth Manager designations. He was one of five finalists for the Professional Adviser Personality of the Year Award 2015 along with the then Pensions Minister. But the award went to a more deserving winner, obviously!
Timeline
Timeline is the sustainable withdrawal rate software used by financial planners in the UK, US and other developed countries across the world. Timeline uses extensive empirical research, asset class returns, inflation and mortality data to assess how a retirement strategy might fare under various market conditions.
All the withdrawal strategies covered in this book can be modelled on Timeline. Financial planners can visualise how these sustainable withdrawal strategies align with a client’s needs, and produce a personalised Withdrawal Policy Statement for each client in minutes.
For more: www.timelineapp.co
FinalytiQ
At FinalytiQ, our aim is to help our clients deliver better outcomes to end investors than they would without our help.
To paraphrase American writer Edward Abbey, financial services is a bit like a stew. If you don’t stir it up every once in a while, then a layer of scum floats to the top. That’s why at FinalytiQ, we like to stir things up every now and then. We pride ourselves in spreading sunlight on the darkest corners of the investment world.
We provide critical analysis, benchmarking and insight to advisers, providers, and asset managers. Our particular areas of expertise include retirement income, investment propositions and benchmarking products/providers.
We support advisory firms with high-quality research and due diligence to create robust investment propositions that deliver superior client outcomes in a compliant way. Through our market analysis, benchmarking and thought-leadership content, we help platforms and asset managers identify their distinct positioning in the marketplace and build propositions that are fit for purpose.
For more: www.finalytiq.co.uk